10 Things I Believe About Saving and Investment

1. The ability to live within one’s means and save significantly trumps saving less and trying (hoping) to earn high returns on it.

Better to spend more time and effort on that which you can control than that which you can’t. And for most people, living within one’s means is a behavioral issue rather than an economic issue.

2. Return ofcapital is more important than return oncapital.

When various asset classes—stocks, bonds, real estate, so on—become obviously overpriced like they are today (September 2016), unless you’re a short-term trader it’s usually better to be patient for more reasonable prices.

Why be out there trying to pick up nickels in front of a steam roller?

Permanent capital loss is most likely to occur when investors indiscriminately buy investments that are overpriced in relation to realistic underlying values, or when they buy investments that are out of sync with the investor’s own time frame.

3. Most people are shocked when they see how much they need to earn back to recover from catastrophic loss in their portfolio.

Catastrophic losses can be hard to stomach at any age, but they can be devastating to folks in the second half of life, due to limited time frame for recovery. The return you must earn just to get back to even grows exponentially.

There seems to be this naïve assumption—and the financial industry is at fault for fostering it—that risk and return are like a knob on an old radio. That if you dial-up your portfolio’s “risk” (more in stocks) you’ll automatically get a higher return.

There are no guarantees and asset classes go in and out of favor over time. There is no automatic cause-and-effect relationship. Stocks have historically outperformed other asset classes over long periods of time, but starting point valuations have a huge impact on the returns you receive over the next 5-10 years.

5. Investors with buy-and-hold, static portfolio models are likely to get creamed with terrible average annual returns over the next 7-10 years.

As I write this (September 2016), US stock prices are at very stretched valuations. Other global stock markets are not at the same extremes, but when the US market heads south other markets often follow suit. Bonds of most types are now yielding a pittance, meaning their prices have been bid way up. There is now over $13 trillion of global debt with negative yields, meaning if you buy those bonds today you are guaranteed to lose money holding them to maturity.Yes, you read that correctly.

We get to thank the global central banks and their monetary policy on steroids for all this.

Now, that doesn’t mean we’ll crash or move into a bear market next week, next month, or even necessarily next year. But how can anyone in their right mind think that a buy-and-hold approach of just sitting in the roller coaster wherever the markets take us from these elevated levels is going to give them any kind of return over the next decade?

It’s not lost on me that I’ve been preaching caution on this for a long time. And I did get too conservative with client portfolios far too early. But it’s better to take a tactical approach, be more conservative now, and then actually have the capital to deploy into good investments when they can be had at much lower prices. Then from those lower prices you should actually have a decent chance of earning reasonable returns over the coming years.

6. A buy-and-hold approach can work but only if:

You have a long enough time horizon to recover from the market roller coaster’s inevitable downturns. This can be a problem for “second halfers” who may need some or all of that money soon.

Your investments are sufficiently diversified such that they won’t go to zero. For example, you don’t have it all in speculative small company stocks or bonds of firms that end up insolvent.

You have the intestinal fortitude to hang on for the full ride down and then back up. And this is the biggy…studies consistently show that everyone thinks they’ll hold on but human nature tends to bail after the market has done its damage and then miss the coming upturn.

7. Total return is everything.

The total return you earn on an investment has two components:

Interest, dividends, and distributed gains +Increase or decrease in price of the investment

Investors are chasing yield wherever they can find it in the current environment of interest rates nailed to the floor. Consequently, this has caused the prices of higher yielding investments to reach elevated levels that would be unimaginable in a more “normal” economic environment.

Folks tend to think of bonds, REITs, and high-dividend paying stocks as being appropriate for the relatively conservative investor. But they seem to be unaware of the potential risk that is now built in to these investments in the current environment. Consider this hypothetical example:

ABC REIT Fund is yielding 5%, but interest rates begin to rise causing the fund to (temporarily) drop in price by 18%.

ABC REIT Fund’s total return for the year is: 5% + -18% = -13%

Well, that didn’t turn out as expected, right? Be very careful to not overdo it in the chase for yield. It’s probably better to be content for now with lower returns of more protective investments (even cash that’s earning a goose egg!) than be overexposed to overpriced income investments.

8. Nobody can precisely and consistently “time the market,” but that’s the answer to the wrong question.

Most of the financial industry, financial authors, and the media treat “market timing” as a whipping boy. There are many types of market timing, but generally speaking all try to avoid loss or outperform by being in/out of the markets (usually stocks) at particular times.

Now, it’s absolutely true that nobody can precisely and consistently time the markets…there are just too many moving pieces and unpredictable events. It’s also true that most active mutual fund managers underperform the index benchmark for their fund.

So what?

Who said anything about needing to precisely and consistently catch a market’s top or bottom? And who said anything about using active mutual fund managers to fill each piece of the pie in a static portfolio model?

Tactical shifts in a portfolio that help avoid large losses and capture a reasonable amount of upside when appropriate can serve an investor quite well. Plus, you’d have a lot less of the portfolio fluctuation that might otherwise make you want to bail at a bad time.

Trend following trading simply follows price trends, with no regard to underlying valuation of the investments. In many respects, it uses a strategy that runs counter to everything else I believe about valuation.

But a good trend following trading system can get you out of markets when they’re falling and keep you in when they’re rising. There’s no attempt to precisely time market tops and bottoms per se, but rather to capture gains out of the “middle.”

And in an environment where global central banks have completely distorted the “markets” and turned valuation on its head (at least temporarily), a system which is agnostic to value and simply follows price can be helpful for some or all of one’s portfolio.

10. Investor time frame is important but it’s a dumb reason to overpay for investments.

Investor age and time frame are important considerations for the type of investments (asset classes) you buy—especially time frame for when you’ll actually need to use the money. But age and time frame are not good reasons to pay top dollar when the assets are obviously overpriced.

Using an example from everyday life:

Why should a 35 year old pay $40,000 for a new Toyota Camry that’s worth $28,000 just because they “have a long enough time horizon?”

It’s not an apples-to-apples illustration, of course because a car is a depreciating asset. But the point is the same…whether you’re buying a car, an investment, or a case of tuna, why overpay if you’re not in desperate need to consume it now?

The car is worth the same $28,000 whether you’re 35 or 65. The investment is worth the same $28,000 whether you’re 35 or 65. Unless you’re a short-term trader, buy when price makes sense.